Are stock markets set up to fool us?

Published in The Sunday Times on March 31st 2024.

Contrarian investors, most notably Warren Buffett, have amassed vast fortunes by being “greedy when others are fearful and fearful when others are greedy”. Buy when there’s blood in the streets, the contrarians tell us.  

Everyone wants to be a contrarian, but it’s logically impossible. There is a hilarious scene in Monty Python’s Life of Brian when Brian, mistaken for the Messiah, tries to convince his followers to think for themselves. “You’re all different!” he cries. “Yes, we are all different” the crowd shouts as one. Then one voice says: “I’m not.” 

All successful investing involves some element of contrarianism. There would be no such thing as an equity risk premium if everyone was indifferent to stock market volatility. It’s not for everybody, hence the contrarians willing to bear it earn a return in excess of lower-risk alternatives.  

Being a contrarian is not just devil’s advocacy 

There is a subtle distinction between unthinkingly dismissing orthodoxy and meaningfully challenging it. A contrarian’s opinions must tally with the market at some point if a strategy is to succeed. It is a willingness to examine the consensus, recognise where it may be flawed and demonstrate that a better answer lies elsewhere. 

But being a stock market contrarian is not easy. There are no rules or repetitive patterns in financial markets and the feedback we get is infrequent or inaccurate. Because of all of this randomness, financial markets are considered to be a poor learning environment for improving skill levels.  

This is in contrast to so-called ‘kind learning environments’, where rules are clear, patterns repeat, and feedback is quick and accurate. Chess, mathematics or musical instruments provide fairly instant and good quality feedback. In these domains, feedback tends to be direct, objective, and largely free from subjective interpretation or randomness. In these domains, you can increase skill levels rapidly because of the ability to course correct based upon the frequency and quality of the feedback you are getting. 

Financial markets are constantly priced throughout the trading day, which would seem to imply very frequent feedback. Much of this feedback is poor quality – it’s just randomness or noise. It takes multiple years to get good quality feedback. And because of this, financial markets can reinforce mistakes or the wrong approach.  

Fooled by randomness 

Financial markets are set up to fool us, as Nassim Taleb, recounted wonderfully in his book, Fooled by Randomness. It is unquestionably the most influential book about investing that I’ve read in the last twenty years. And it has a thing or two to say about volatility and how the human race is not well adapted to deal with randomness.  

There is a difference between a process being random and the product of that process appearing to be random. Apple ran into this problem in the early stages of the iPod with its random shuffle.  

True randomness sometimes produces repetition, but when users heard the same song back-to-back they complained the shuffling wasn’t random – “My shuffle won’t shuffle”! Apple changed the shuffle with Steve Jobs ironically noting, “We’re making it less random, to make it feel more random.” 

We don’t deal well with randomness 

This is Taleb’s point in the book - we don’t deal well with randomness and ultimately end up being fooled by it. Chance or luck plays a greater role in our lives than we think. And this has important and far-reaching consequences in relation to investment markets and how you think about investing. 

Taleb is very irreverent as regards the investment management business in the way he explains the effect of randomness. He sees success in the investment arena to be largely the result of a highly random process.  

“If one puts an infinite number of monkeys in front of a typewriter, there is certainty that one of them would come out with an exact version of the Iliad - Would anyone bet their life savings that the same monkey would write the Odyssey next?” 

I don’t agree with Taleb’s assertion that financial markets are hopelessly random. Stock markets run on narratives. So do human minds, as it’s easiest to think in terms of stories. Sometimes the stories we tell, or are being told are false and lead us astray. But that doesn’t mean that there isn’t any purpose or signal or that we shouldn’t try and find it. 

You must know where you are going and have a plan in place 

The contrarian’s badge of honour is ignoring the market consensus – complete dispassion in the face of constant noise. To do this successfully you need to be very confident about the direction you are going and have a robust process in place to be able to ignore the constant distractions.  

Being fooled is a fundamental experience of childhood – by Santa Claus, the easter bunny or by the idea that you’ll glue your insides if you swallow chewing gum. The stakes ratchet higher in adulthood if you end up being a mark, particularly in financial markets.  

Seek advice and have a proper plan. And if you haven’t read Taleb’s book, you should put it on your list.  

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.